A wise investor targets the research, not broker forecasts

I got an email from one of my members this week asking if I could explain why broker forecasts vary so much. The example they gave was Mount Gibson (MGX). As I write it is trading at $1.07 but current broker target prices range from 48¢ to $1.20. Given brokers are looking at essentially the same production data you have to ask, how does one see 12 per cent upside while the other sees 55 per cent downside?

Method

There are many different ways to calculate the value of a company so if you want to make sense of a piece of research and understand a target price, you need to know which one they are using. To work that out there's no alternative: you need to read the research.

This trend towards snapshot research opinions is too simplistic and belies the truth and value in the research. If all you do is look at target prices you could well be comparing apples with oranges and if all you do is judge analysts on performance against target prices you are being unfair. Good analysts hate the target price trend, to summarise the research in a single unqualified target price cheapens their considerable work. All valuations ''could be this or it could be that, depending on these factors'' but the broking houses that employ the analysts are playing a rather less intellectual game and asking them for one number because it is commercial, easy to communicate and creates trade.

These are the percentage moves in the 10 sectors that make up the S&P/ASX 200 Index.

But that's not what research is about. Research is about understanding a company and its influences and while an analyst may give you their best guess at what is going to happen, the real value in the research is for the reader to get an ''understanding'' for himself, not for the writer to distil it to a target price for which he or she will be abused. Actually reading the research enables you to make your own assumptions and form your judgment about the future direction of value and hopefully price.

The new target price trend is pandering to the new commercial norm of brokers trying to get their name out there by giving away their research like quasi marketing ''confetti''. My advice to the investor is ignore the target price; it tells you nothing. Instead, read the research and ask yourself ''Why did they come up with that target price?'' and then seek the answer.

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And in defence of the analysts that have to play this game, they almost certainly know more about the company than you so if you abuse them for their target price and recommendation it is almost certainly you that hasn't understood, not them.

Assumptions

You cannot act on a Rio or BHP target price, for instance, without knowing the iron ore price assumption behind it. Small differences in factors, such as commodity price assumptions, interest rates, currency rates, exploration success and 100 other elements, make big changes to valuations and earnings forecasts. You can find brokers working off the same data with a completely different recommendation and target price. It is all down to the assumptions. You have to ask ''What are they and do I agree?'' To do that, you have to delve deeper again.

Corporate relationship

This is a controversial subject but remains a reality as long as brokers earn fees from companies for raising capital by selling their equity and sorry, but the disclaimers and disclosures are still not upfront enough, they are ''down back'' and buried in some cases in pages and pages of small print. Brokers only write research on stocks for a reason: to create trades or to market a fee-paying client. In the case of the latter, they are not going to say sell.

On top of that, with larger companies, any broker that says sell is cutting themselves off from potential future fees. Why else is there a history of almost universal buy recommendations on BHP and RIO despite them both underperforming the market by about 30 per cent over the past three years.

Bottom line, you have to read the research to get value out of it. The target prices and recommendations may be the first thing you read, but they are the last thing you act upon.

Marcus Padley is the author of the sharemarket newsletter Marcus Today.